DP5259 The Empirical Failure of the Expectations Hypothesis of the Term Structure of Bond Yields

Author(s): Lucio Sarno, Daniel L Thornton, Giorgio Valente
Publication Date: September 2005
Keyword(s): expectations hypothesis, term structure of interest rates, vector autoregression
JEL(s): E43, G10
Programme Areas: International Macroeconomics, Financial Economics
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=5259

This paper tests the expectations hypothesis (EH) using US monthly data for bond yields spanning the 1952-2003 sample period and ranging in maturity from 1 month to 10 years. We apply the Lagrange multiplier test developed by Bekaert and Hodrick (2001) and extend it to increase the test power: (a) by introducing economic variables as conditioning information; and (b) by using more than two bond yields in the model and testing the EH jointly on more than one pair of yields. While the conventional bivariate procedure provides mixed results, the more powerful testing procedures suggest rejection of the EH throughout the maturity spectrum examined.